Sectors to Consider if Inflation Continues to Rise
The beaten-down sectors from 2020 might be worth another look in 2021
In general terms, the bond market will rally when increases in the Consumer Price Index (inflation) are small and the bond market will fall when increases in the CPI are large. The equity markets generally follow the same trend as the bond market when responding to CPI numbers. In other words, the equity market will (generally) rise when CPI numbers are small because low inflation leads to low interest rates, which are good for corporate profits.
But are there certain S&P 500 sectors that might perform better if inflation rises?
Inflation Rose in November and December
On January 13th, the U.S. Department of Labor was reported that the Consumer Price Index for All Urban Consumers increased 0.4%, after rising half of that (0.2%) in November. Further, from the U.S. Bureau of Labor Statistics:
Over the last 12 months, the all items index increased 1.4% before seasonal adjustment.
The seasonally adjusted increase in the all items index was driven by an 8.4% increase in the gasoline index, which accounted for more than 60% of the overall increase.
The food index rose in December, as both the food at home and the food away from home indexes increased 0.4%.
The index for all items minus food and energy increased 0.1% in December.
In addition, the indexes for apparel, motor vehicle insurance, new vehicles, personal care, and household furnishings and operations all rose in December. The indexes for used cars and trucks, recreation, and medical care were among those to decline over the month.
Where to Invest During Rising Inflation
Generally speaking, financial advisors would suggest that cash is one of the worst asset classes to hold during rising inflationary periods. And in theory, there are some sectors that generally perform better than others if inflation rises.
For example, when there is high inflation, companies will pass the rising costs onto consumers, right? And it stands to reason that if you and I become more selective when we purchase goods and services, we might forgo some luxury items (think jewelry), but we will keep buying basic necessities (like bread and milk). And that explains why the Consumer Staples sector generally perform better during rising inflationary periods and the Consumer Discretionary sector generally performs worse.
Gold (and Gold Stocks)
Generally speaking, institutional investors often turn to perceived “safe” investments like gold and gold stocks when inflation is on the rise. Why? Well because gold is considered to be safe haven during periods of economic instability.
Energy (Oil and Oil Stocks)
Interestingly, there is a positive correlation between the price of oil and inflation. In fact, according to the St. Louis Federal Reserve:
“The graph shows a strong positive relationship between oil prices and PPI inflation: That is, higher oil prices are associated with higher producer prices and vice versa. Specifically, the correlation between oil prices and the PPI is 0.71. This strong link likely comes from the importance of oil as an input in the production of goods.
Utilities are generally considered defensive as we all still need them (think electricity, heat, gas, etc.) no matter the inflationary environment. And since energy companies pass any higher costs onto us, they are able to maintain their profitability.
Real Estate Sector
The Real Estate sector is often a hedge against inflation too. Consider the largest component of the sector – Real Estate Investment Trusts. REITs own and operate income-producing real estate and property prices and rental income tend to rise when inflation rises. Further, REITs are required by law to pay out at least 90% of their net earnings to shareholders annually.
Want more proof on the importance of asset allocation and diversification in one’s portfolio returns? Consider the performance of the sectors just mentioned last year (save Gold):
S&P 500 Sector: 2020
Notice a pattern? Again, those variations are the epitome of sector rotation and the numbers empirically identify the importance of asset allocation and diversification for all investors.
But last year’s sector performance might suggest that if inflation does indeed rise in 2021, last year’s beaten-down sectors might be worth another look.